An extremist, not a fanatic

March 01, 2011

How bonuses backfire

Could it be that bonuses, far from incentivizing people, actually lead to lower effort and output? There’s already some evidence that they are inferior to fines. But here’s a separate line of thinking that yields the same conclusion, that bonuses backfire.It’s what Eyal Winter has called incentive reversal (pdf). Imagine a team of workers who jointly produce outputs. An individual worker might decide that it is only worth working hard if others do so too. He might figure: “if I work hard whilst others slack off, the team won’t make its targets anyway and I’ll be just a mug.” Under this arrangement, workers collectively might or might not work hard.But then imagine that high bonuses are introduced. Individual thinking might then change: “My colleagues will work hard to chase their bonus whatever I do, so I might as well slack off. That way, I get the bonus without effort.”In this way, it’s possible that the introduction of bonuses might reduce effort and output.This is just a hypothesis. But some laboratory experiments at the Hebrew University of Jerusalem have shown that it can apply in practice. They’ve shown that even quite modest increases in bonuses can lead to a halving of effort.There’s an important theoretical point here. The glibertarian cliché that incentives matter is true, but not in the sense they intend; sometimes, incentives can backfire, as in the now well-known instance (pdf) of the introduction of fines for parents who are late picking up their kids from kindergarten.But does this have practical relevance? It hinges on whether an individual’s effort is directly observable - that is, whether he can get away with free-riding. This in turn will depend upon management structure. If managers, who decide bonuses, can closely monitor individual workers, the problem won’t arise. If, however, managers sit remotely in their boardrooms then it might.And herein lies a curious fact about bonuses in investment banking. In the old days - especially before Big Bang but also for some time afterwards - bonuses were set by the firms’ partners who worked on dealing floors alongside their staff and could monitor them closely. This system worked tolerably well: many of the old English broking firms had survived for decades. However, when investment banks became units of larger firms, with more remote management, they quite soon collapsed. Isn’t it a strange coincidence how this story of investment banking is consistent with the theory and laboratory evidence for incentive reversal?A note: by “slacking off” I don’t mean merely obvious tactics such as taking sickies. There are more subtle means of doing so, such as going for easy risky trades rather than putting in the effort to find risk-adjusted profits.

Comments

So... performance-linked bonuses are only effective when performance is adequately measured? Shocking! And a better approach is to place a cap on bonuses so that the companies that *do* use them effectively can no longer do so, while those that use them poorly are shielded from their folly and remain active in the marketplace for longer?

PS – A bit rich to take a swipe at libertarians for being glib while in the same sentence oversimplifying to the point of idiocy their position on incentives, isn’t it? I’d have thought even the most vulgar of libertarians would argue that actual incentives are not always the same as intended ones – indeed, isn’t the Law of Unintended Consequences the bedrock of all libertarian scepticism about government action?

I have worked in many investment banks. I can assure you that people focus very hard on their bonus, and work for it.
If there is a problem, or an unintended consequence of bonuses it's that people deliver very precisely the numbers/behaviours that are rewarded in a bonus .. and don't worry about anything else. If' it's not part of the bonus calc it's not important. They also might achieve the numbers/behaviours in ways that the management might not have anticipated.

The difficulty I have with bonuses is that, on the whole, they seem to be paid for the individual to do the job they're paid for. This view is strengthened by what appears to be the contractual nature of bank bonuses.